Sustainability in the business world is currently in the cross hairs of the European Union. Recent introductions have seen certain environmental criteria far beyond the economic level gaining greater importance: the SFDR, a new EU sustainability regulation, is ripe with requirements that must now be taken into consideration. In this article we’ll have an in-depth look at its key objectives and the requirements it sets out.
What is the SFDR?
The Sustainable Finance Disclosure Regulation establishes the minimum standards that businesses must meet when disclosing information. It is a reference framework that aims to propel companies towards a sustainable future through transparent disclosure with the help of a specialised set of standards, practices and metrics.
The Future of Sustainability in Investment Management: From Ideas to Reality report, published by the CFA Institute in 2020, serves to further back this up. Finances continue to place ever more value on sustainability as a key criteria. As such, European institutions have introduced this transparency guide as part of the EU’s action plan to tackle the issue.
The regulation was passed in 2019, although it didn’t come into force until 10 March 2021. Later, two further disclosure requirements were added to it. Nowadays, it is vital to understand the SFDR and know exactly what it is:
- In 2022, the concept of PAI (Principal Adverse Impacts) regarding sustainability was introduced.
- In 2023, PAIs were reclassified and companies are now obliged to collect data from January onwards.
The enforcement of this regulation will signify a great step forward in terms of transparency and sustainable finances. Now it is essential for adverse markets to report on risks to sustainable development, allowing investors to decide to provide financial support only to the most environmentally friendly proposals.
One of the main benefits of this policy is the increased weight it places on financial decisions. The intention is to gradually shift the investment outlook of the European Union and, as a consequence, make companies that are more environmentally aware look more attractive to those who provide capital.
What are the goals of the SFDR?
For years, the elimination of greenwashing, one of the most controversial practices in finances, was targeted as a priority by EU institutions. Some companies altered their reports to make it seem as though they did more to care for the environment than they actually did. The SFDR was born of the need to provide a reference framework that would help prevent such behaviour.
Another of its objectives is to align investment decisions with sustainability goals, shifting the onus onto businesses by devising a new way in which they can obtain compensation. Beyond awarding public grants to those that make progress towards ecological transition, this system will also help attract private financing.
The third goal is to help companies identify their sustainability objectives and keep up with public opinion. The idea is to bring to the fore factors that until now have been of secondary importance, among which are the fight against corruption, workers’ wellbeing and other socially responsible aspects.
Who does the SFDR affect?
With the introduction of this new regulation, the EU has made it a requirement for many types of organisations to report on such non-financial aspects of their business. Financial advisors and financial market participants must apply these new rules, and so too must investment companies, credit institutions, large asset owners and portfolio managers.
Bodies managing investment or pension funds, as well as insurance companies, must also adopt these policies. Any company that is bound by the regulation can consult the document to find out exactly what its obligations are when it comes to identifying and disclosing their socially responsible objectives in a standardised manner.
With regard to the potential impact that it may have on companies, given that it is now vital they report on how they are tackling climate change, as part of this new regulation they will have to put in more effort to make progress in certain environmental and ethical criteria. Aside from just reporting on their corporate objectives, what’s more, they will now have to report on exactly how they are addressing them.
When an entity designs or manages a sustainable product, it must go into much further detail when implementing these criteria. For example, investment companies have to specify which of their products have the greatest environmental footprint. As such, they are required to disclose the assets that each fund is composed of.
One of the most challenging issues for businesses is the distribution of each activity: when the time comes for a company to disclose information on its sustainability, it must break down the activities into different levels, allowing it to indicate with what level of compliance it is combating its environmental impact.
What are principal adverse impacts?
Principal adverse impacts (PAIs) are the main KPI used in this field, which track the negative effects that a company’s activity may have on sustainability. In other words, it shows the aspects in which the company, due to its nature, is furthest away from meeting society’s demands.
The goal of this metric is to act as a deterrent in the fields of financial advice, planning and decision-making, and as a result providing investors with more information on the consequences of the negligent use of capital. There are 64 indicators, according to the latest update in 2023, which are broken down into two types: mandatory and optional.
Each one is further divided into sub-blocks: social and environmental. They can even be classified based on their scope, whether sovereign, corporate or real estate. The ultimate goal is to realign actual performance with the expectations of the financial market in order to displace revenue as much as possible.
Classification of investments under the SFDR
As detailed in the Final Report on draft Regulatory Technical Standards, published by the European Securities and Markets Authority in 2021, there are a number of key indicators, some of the most important of which are greenhouse gas emissions and the use of fossil fuels.
Depending on whether or not an investment product includes aspects related to these two criteria, it is placed in one of the following three categories:
Article 6. Products that integrate sustainability risks
Known as article 6 products, these hinder the achievement of the environmental objectives. They are represented by the colour grey and they must be reported transparently.
Article 8. Products that promote sustainability characteristics
Called article 8 products, they promote goals that are not recognised by the European Commission. However, they may still contribute to sustainability in some way.
Article 9. Products that have sustainable investment as their core objective
Article 9 products are completely aligned with the European Commission’s environmental strategy. They follow responsible principles and have adopted practices in line with the EU’s taxonomy.
Regulatory requirements on disclosure of sustainable finances
The new EU directive states that organisations must regularly report on how they tackle each of these different issues. Under the regulatory framework outlined in the SFDR, reports must consider the following aspects:
- The risk that investment decisions or advice may pose to sustainability.
- The principal adverse impacts of the business activity.
- The inclusion of sustainability risks in retributive policies.
- Pre-contractual information linked to the progress of an investment.
In terms of the products, there are three colour levels that tell us whether or not they promote environmental characteristics.
How can I comply with the SFDR?
Its publication in 2023 saw the introduction of a number of deadlines that businesses have to meet. Some dates that must be observed are:
- 1 January 2023. Start of the second reference period (known as level 2), which will last until 31 December 2023. Required businesses must begin collecting information that will later be turned into transparent data.
- 30 June 2023. Limit for reporting on conclusions of the reports published regarding the first reference period (1 January to 31 December 2022). These must include social and environmental principles that clearly show what the company has done in this regard.
- 30 June 2024. Deadline for reporting on the conclusions of the second reference period. The SFDR standards must be followed when preparing these reports. From this date on, companies will also have to prepare a year-to-year comparison of the reference periods and determine whether or not progress has been made.
There are three values that must be at the core of the KPIs devised and applied by each company:
- Sustainable objectives. These must signal the path that the company wants to take, why and how it intends to get there.
- Sustainable actions. The collection of actions that the company will take to adopt a socially responsible policy.
- Monitoring procedures. Measures designed to check the scope of the objectives and their relationship over time with predictions.
There’s no doubt that the SFDR gives the business world lots to think about. No longer enough to rely solely on their capacity to produce in order to make profits, companies are now required to incorporate ethical and sustainable criteria. In the future, further changes are expected which, sooner or later, will also have to be taken on board by companies.
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